Yes you should, i'm sure she would really appreciate it & it would have a lot of sentimental meaning. Why not wrap it in some tissue paper & give it to her along with the card with a message i'm explaining why you are giving it back?

IS she having any kind of celebration when she gets her little girl? That could be a good time to bring it up. If not though I think it'd be a case of saying something short like "I know your granddad made this for your daughter, I now you have a little girl I thought she should have this". I imagine it will mean a lot to her.